Lesson 1 of 5 · 12 min
The three sources of return on a fixed-rate bond
A fixed-rate bond pays you through its coupons and principal, through interest earned on reinvested coupons, and through any gain or loss if you sell before maturity.
In short
- Three sources of return: (1) the promised coupons and principal, (2) reinvestment of the coupons, (3) a capital gain or loss if the bond is sold before maturity.
- Your realized return equals the YTM at purchase only if you hold to maturity, the issuer does not default, and every coupon is reinvested at that same YTM.
- Compounding reinvested coupons adds interest on interest: the future value of the coupons exceeds their simple sum.
- Interest income is the return from the passage of time: coupons, their reinvestment, and amortization of any purchase discount or premium.
- A capital gain or loss comes only from a change in the bond's YTM: a sale above (below) the carrying value on the constant-yield price trajectory.
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